BackEnding India’s boom and bust cycles
The road is likely to be rocky with the fiscal burden, but a rethinking on financial liberalization is needed
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The rupee has lost nearly one-fifth of its value against the dollar in the past one year. With economic growth decelerating to 5% in fiscal 2013, the current account deficit rising to 4.6% of gross domestic product (GDP) and inflation measured by the Consumer Price Index remaining close to 10%, India is unmistakably in a crisis.
How did it get into such a dire state so quickly, from a stellar performance till two years ago?
For a credible answer, which is the key to finding a solution, one needs to step back a little to view India’s economic performance over the past decade as an episode of cyclical boom and bust, culminating now in the crisis (for a detailed version, refer to “India’s Dream Run, 2003-08: Understanding the Boom and its Aftermath," Economic and Political Weekly, 18 May).
For five years from 2003-04 to 2007-08, India grew at an unprecedented rate, close to 9% per year. It was an export-led growth with the export-GDP ratio going up from 14% in 2003 to 25% in 2009, largely on account of information technology (IT) outsourcing and capital-intensive manufactures. India’s exports are known to follow the cycles in world trade, which grew at 16.5% per year in the six years since 2002-03, compared with just 3% per year in the previous six years. The IT boom was truly remarkable, contributed by the IT and communication revolution, and the financial deregulation in the US. India seized the opportunity, leveraging its human capital within its diaspora employed in Wall Street firms and US academia to create an export success.
The output boom was largely domestically financed, with saving and investment rates going up by nearly 10 percentage points, to 35-37 % of GDP by 2007-08, touching the levels attained in East Asia. For the first time, the private corporate sector became the main engine of growth, contributing nearly half of domestic investment, financed by a growing share of bank credit, topped up by unprecedented foreign private capital inflows. At their peak in 2007-08, the inflows—the sum of foreign direct investment (FDI), foreign portfolio investment (FPI) and external commercial borrowings (ECBs)—totalled 10% of GDP, when current account deficit (CAD) was 2.5% of GDP and trade deficit 7.4% % of GDP.
The fiscal deficit declined during the boom as public revenues swelled and public investment was curtailed in favour of the private sector (including foreign capital). Macroeconomic conditions were kept benign: low interest rates, moderate inflation and balance of payment, while foreign exchange reserves accumulated steadily, because of capital inflows rather than a trade surplus (as was the case in China).
Capital inflows surged into emerging market economies in search of higher yield, as monetary conditions were easy under US Federal Reserve chairman Alan Greenspan, after the Internet bubble ended. From the demand side, financial liberalization eased inflows as the definition of FDI was loosened to follow the International Monetary Fund’s (IMF) guidelines; and was permitted into real estate, unlisted companies and special economic zones (SEZs). Interestingly, just about 40% of the FDI inflow contributed to productive potential. An equal share was contributed by private equity, venture capital or hedge funds, whose contribution to augmenting productive potential is suspect. About 10% of FDI represented round-tripped capital from India via tax havens such as Mauritius.
ECBs were permitted for large firms to reduce their interest costs, regardless of the foreign exchange saving or earning potential of such investments. Foreign portfolio investment (FPI) was encouraged, largely overlooking the ultimate source of such funds (the much disputed participatory notes) that caused an initial public offerings (IPOs) boom. Primary stock market mobilization shot up from 0.1% of GDP in 2002-03 to 1.4% of GDP in 2007-08. Skyrocketing stock prices lowered the cost of capital.
The capital inflows, however, did not raise concerns of external indebtedness as public sector debt (from official and multilateral sources) contracted. However, the debt composition turned adverse as the tenor of debt declined, and the share of short-term debt climbed from 5% of total external debt in 2004 to 20% in 2008.
Unlike many recent episodes of debt-led growth raising domestic consumption, this one resulted in an investment boom. The sectors that secured an increase in investment share by 2007-08 were factory manufacturing, construction, and non-government services (possibly private education and healthcare). Surprisingly, infrastructure’s share went up by just two percentage points, to 22% of total fixed investment by 2007-08, although infrastructure’s share in bank credit shot up to 30% of total bank credit. Despite much avowed policy commitment, the additional power generation capacity created was modest, far below what was witnessed in the 1980s and early 1990s. Similarly, despite a flood of credit for housing, the share of residential construction in the total declined; instead commercial estate’s share went up significantly. So, these trends provide reasons to suspect that a substantial share of the credit and fixed investment was perhaps diverted to real estate, contributing to rising asset prices across the country.
The 2008 global financial crisis punctured the boom. Expectedly, FPI fled for the safety of the dollar, but returned as the panic subsided. Like most countries, India eased its monetary and fiscal policies to boost domestic demand. For instance, the government quickly implemented the pay revision for government employees that expectedly reversed the fiscal consolidation. The quantitative easing (QE) in the US perhaps sustained foreign capital inflows, causing currency overvaluation in 2011 and 2012.
However, output growth slowed as the effect of the stimulus tapered off, and as external demand failed to revive because of the Great Recession. Tightening outsourcing rules for firms and visa restrictions in the US (as exemplified by the Buy America provision under US law) hit the IT industry, even as the Philippines nibbled away at the low-end, voiced-based services. The current account deficit began to climb as output growth slowed and exports decelerated.
Macroeconomic conditions turned adverse after 2009 as inflation and interest rates rose; oil prices were partially allowed to pass through. As a result, debt servicing by the private corporate sector turned difficult under the changed circumstances. This in turn impaired the banking sector’s balance sheet. As, reportedly, 40% of corporate debt is in external currency, most of which is unhedged, the cost of debt servicing soared as the domestic currency value declined. By March 2013, nearly 80% of the national external debt (of $390 billion) was held by the private sector, 30% of it commercial borrowings and 25% short-term debt.
If the above narrative has captured the essence of the external debt-led boom and bust cycle, then the current crisis is an entirely believable outcome of financial liberalization. India is not alone in experiencing a currency collapse. Indonesia, Turkey, Thailand and Brazil that have also been hit by capital outflows, perhaps making it a crisis of the emerging-market economies.
As Rudiger Dornbusch, the distinguished macroeconomist, observed in 2001, after the Asia financial crisis, “The corporate sector, like the banking system, has balance sheets that are vulnerable to mismatch with respect to both maturity and denomination. The larger the corporate sector’s short-term debt in the national balance sheet, the more vulnerable the country is to a funding crisis which then becomes a currency crisis. Once again, in emerging markets, when credit to a particular sector is withdrawn, it is a capital outflow rather than a substitution into other assets. Consequently, balance sheet problems become currency crisis issues."
Access to foreign capital surely relieves credit constraints on domestic firms. If the additional investment does not earn commensurate foreign exchange, or if it does not substitute for equivalent imports, then the trouble begins. If a country hopes to borrow short term to repay long-term creditors, then the nation’s economic policy becomes hostage to the whims and fancies of currency traders. John Maynard Keynes had warned, “When the capital development of a country becomes a by-product of the activities of a casino, the job is likely to be ill done. The measures of success attained by Wall Street, regarded as an institution of which the proper purpose is to direct new investment into most profitable channels in terms of future yields, cannot be claimed as one of the outstanding triumphs of laissez faire capitalism…"
How India is going to finance the external deficit of reportedly $70 billion in the next one year, and at what cost to the nation, is the crux of the problem now.
If the foregoing diagnosis is correct, then, a rethinking is needed on financial liberalization. Perhaps the virtues of capital controls need to be recollected. They helped India escape the Asian financial crisis, a policy that even the IMF now cautiously advocates. Once external balance is restored, the task would be to revive investment demand. As the debt-laden private corporate sector will not be up to the task, stepping up public infrastructure investment, following Keynesian percepts, and extending credit to agriculture and informal sector to augment of wage goods production will be a pragmatic move. The road is likely to be rocky with the additional fiscal burden, but perhaps less riskier than fishing in the troubled waters of global capital markets.
R. Nagaraj is professor, Indira Gandhi Institute of Development Research, Mumbai.
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